TRADER'S NOTEBOOK

10 Signs That Tell You When To Stop Trading

11/09/11 01:57:57 PM PSTby Matt BlackmanEverybody is hunting for the best buy signals, but this focus ignores a major trading reality: You don't earn a penny until you sell. And you won't keep it if you don't know when to sit on your hands.

Making money in the markets is a 10/90 proposition - 10% buying and 90% selling, according to trader Larry Williams. But take a look at any trading system or service out there and you'll find they have one thing in common - generating buy signals. When exit signals are mentioned, it's almost as an after-thought to the main message. Educators and systems developers will tell you that the sizzle comes from getting into the trade, leaving students to learn about money management strategies, including when and how to exit on their own.

It is the same old story when it comes to staying out of the market. How many trading books have you read or seen advertised that teach you when to sit on the sidelines than be invested? Not many!

Why not? It's simple. Exit strategies, money management, and stepping aside simply aren't sexy. Meanwhile, traders are happy to spend a bundle to get the latest buy signal, even though they don't put a penny in their pockets until they've sold. And it's easy to lose it all by trading an ugly market.

With these realities in mind, I thought it was high time to examine signs used by a well-known trader to see what he looks for when he's exiting trades and what keeps him out of the market altogether.

These are lessons that Dan Zanger, host of ChartPattern.com, had to learn the hard way. It was an expensive lesson but one that he says is necessary for all traders need to learn if they want to be successful. And what he learned stood him in good stead in 2011.

SUMMER OF OUR DISCONTENT After bottoming in July 2010, stocks began to rally again, and by May 2, 2011, the Standard & Poor's 500 had risen 35%, prompting many to believe that the bulls had returned. But market action following the May peak caused Dan Zanger to become defensive. He commented in the May 4th issue of his newsletter, The Zanger Report, that his market-leading stocks, which at the time included Baidu.com (BIDU), Sina.com (SINA), Sohu.com Inc. (SOHU), and the Direxion Triple Bull ETF (TNA), had all plunged from their late April highs ahead of the SPX and had taken out his stops. It was a powerful warning that something had changed. Other leaders such as Amazon (AMZN) and Apple (AAPL) were still strong and looked to be putting in bull flag/pennant continuation patterns.

Another of his past market leaders, the ProShares Ultra Silver exchange traded fund (ETF) (AGQ), had been cut in half since its late April peak, which was another reason for concern. On his DanZanger Twitter feed, he offered his take, commenting that "no need to trade all the time...sitting in almost all-cash - new buys will be built from this action."

A week later, he noted that the neckline of the bullish inverse head & shoulders pattern on the SPX had been breached, which was another good reason to become more defensive: "It's situations like this that tempt dip-buyers to get back into the market and that can be very costly before you get the right confirmation."

On May 11, there was another warning. The AMEX Securities Broker/Dealer Index (XBD) showed a pattern that spelled lower prices ahead. And on May 13 alone, it dropped nearly 5% and continued to fall (Figure 1).

In early June, Zanger discussed a bearish head & shoulders pattern that was near completion on the SPX in his newsletter (Figure 2). This pattern together with the one on the Russell 2000 (Figure 3) showed a market on the edge. This rounding top forming on the Russell 2000 index that he warned of in his June 10th newsletter was significant, since this index had a habit of leading larger-cap indexes in both rallies and corrections.

FIGURE 2: BEGINNINGS OF BEARISH HEAD & SHOULDERS PATTERN THAT BEGAN TO EMERGE ON S&P 500

Stocks dropped across the board into the middle of June then started to stage a comeback. But it was a bear market rally. On June 24, the SPX moved back up to fill the gap from the day before and then sold off. And there were other signs of trouble.

On June 27, Zanger discussed the bear channel forming in the SPX that implies lower prices. This was further confirmation of the large topping pattern in the Russell 2000 index. But there was still money to be made by those who were quick on the draw and didn't overstay their welcome. However, the risks of playing the game had greatly increased.

When the SPX put in a lower high on July 7, worry was growing that US politicians would fail to reach an agreement on the debt ceiling as the August 2nd deadline grew near. Even though the major indexes were falling, some market leaders like AMZN and AAPL continued to rise until the end of the month.

But then everything began to drop, causing Zanger to get more defensive. By July 28, he was back to mostly cash, a position he maintained for the most part until the second week of October.

Here is a summary of the 10 signs that Zanger uses to measure reversal risk. He's not a big fan of shorting stocks; he believes going short in a bear market is a risky business, especially near the beginning of the correction, because any good news can propel stocks temporarily much higher, which can be costly to those on the wrong side of the trade. Like the use of margin, selling short is only for the very experienced with an account that can withstand a powerful bear rally.

TEN SIGNS THAT TELL YOU IT'S TIME TO EXIT

When leading stocks turn from strength to weakness, the trend has changed. The corollary is that until market-leading stocks break down, the rally isn't over.

A transition from bull to bear will be further evidenced by the failure of bullish chart patterns in leading stocks and the appearance of an increasing number of bearish patterns such as head & shoulders, rounding tops, bear flags/pennants, and double/triple tops. As Figure 4 shows, the SPX broke head & shoulder top neckline support on August 3 and continued to drop from there, which was very bearish for the markets. This was accompanied by the failure of bull flags and other bullish patterns in some market-leading stocks.

FIGURE 4: DAILY S&P 500 SHOWED CONSECUTIVE BREAKS IN SUPPORT. First it broke a bearish head & shoulders neckline, then a major support line and finally, another major support line at around 1177. Trying to buy when an index or stock when it looks like a falling knife is not recommended.

Commodities plunging ahead of or along with stocks is another warning sign. Silver and some other commodity stocks had already suffered big drops by early May, which presaged drops in the stock market.

Volume surges as prices fall is another sign of the bear and shows that an increasing number of investors are selling and/or short-selling. A trend change from bullish to bearish is a significant event, and volume is the fuel that drives this move. And the greater the increase in selling volume, the more bearish it is - up to a point. If selling volume suddenly spikes after a period of falling prices, it could also signal a capitulation bottom and the beginning of a new bear rally. See Figure 5.

FIGURE 5: APPLE VOLUME INCREASED TOWARD PEAK IN LATE JULY BUT THEN INCREASED AS PRICE ROLLED OFF TOP. This is a clear indication of an increasing number of sellers as the price falls.

Bear market rallies can be both powerful and tempting, but you should resist them as they are usually short-lived. Another tip from Zanger is to avoid buying gap-ups in a bear market. Stocks will often move lower after filling the gaps.

The flipside of increasing selling volume on falling prices is declining volume on rising prices. Any rally during a bear market is suspect until a new bull rally has been confirmed, supported by steadily increasing volume.

Higher than average failures of bullish chart patterns is another warning sign. As Zanger says, a pattern failure can also be a powerful signal. The failure of a bull flag, pennant, or inverted head & shoulders pattern often signals a short if you are so inclined and can move in and out of the trade quickly.

Extreme volatility accompanying a bear market makes playing options expensive. When option-implied volatility increases dramatically, it's another indication that caution is advised. It's often better to wait until option premiums return to more normal levels before trading.

News can be a powerful mover of stocks, and how market participants respond to news is a good indicator of market health. During a bull market, stocks discount bad news, and during a bear market, they discount good news. According to Zanger, bear markets commonly experience morning rallies that morph into losses by day's end. The opposite is true in bull markets.

Bear market rallies have favorite days and other rules. During bull markets, Mondays are often weakest and action picks up as the week progresses. In a bear, Fridays and the days before holidays are hardest on stocks, since market participants are less inclined to hold over weekends. And no matter which market you're in, it's not a bad idea to employ the half-hour rule, Zanger says. For the first 30 minutes of the day, it is riskier to buy a stock that gaps up in price. If the price holds after this period, it is considered safer to buy. Zanger finds this rule works better after the market has moved up for a few weeks but is less effective at the start of a new strong move.

Matt Blackman is a full-time technical and financial writer and trader. He produces corporate and financial newsletters, and assists clients in getting published in the mainstream
media. He tweets about stocks he is watching at www.twitter.com/RatioTrade Matt has earned the Chartered Market Technician (CMT) designation.